In February 2009, I reviewed the operations of the 12 largest U.S. banks, and concluded most of them were sound.

In fact, I told Money Morning readers that the soundest were at that point excellent investment opportunities.

Judging by the performance of the Financial Select Sector SPDR (NYSE: XLF) Exchange-Traded Fund (ETF) since that time, one thing is clear: If you'd followed my advice you would have more than doubled your money.

Yes, the market's up, too, but not to that degree – so it's reasonable to say that I feel a quiet satisfaction over my early analysis of that troubled sector.

A Tough Act to Follow

Unfortunately, the U.S. banking-sector outlook for 2010 is not so rosy. Not only would you be buying at roughly double the price of February, but the sector's prospects are considerably grimmer than they were just a few months back.

I didn't get everything right in February. You can quibble only slightly with my ratings of banks: For instance, State Street Corp. (NYSE: STT) has been nothing like the solid player I predicted at the time, while Capital One Financial Corp. (NYSE: COF) has had less difficulty with its credit-card portfolio than I expected.

Overall, however, I was mostly right.

What I got wrong was my advice to readers to buy the shares in the top-quality banks: You actually would have fared better by investing in the lousy ones. Instead of the 100% you would have reaped by following my strategy, you could have made roughly 90% by now on Bank of America Corp. (NYSE: BAC), which I had dismissed as a "zombie," and about 210% on the "walking wounded" Capital One.

And if you'd waited until early March – when true despair ruled – you could have earned even more on the king of the "zombies:" Citigroup Inc. (NYSE: C).

Bad banks turned out to be the better investment than good banks for two reasons:

First, the government has intervened heavily in the banking sector, even since February. The "stress tests" were carefully designed so that everybody would pass, while the public investment in Citigroup was converted from preferred stock into equity on what looked like very favorable terms. Little or nothing has been done to break up the largest banks that had caused the problem; indeed, the only sanction on them has been for a "Pay Czar" to step in and limit the pay of their 25 top executives. Conversely, the good banks like U.S. Bancorp (NYSE: USB) and BB&T Corp (NYSE: BBT) were forced by the threat of state intervention to raise new equity to repay TARP (Troubled Asset Relief Program) money, and to cut their dividends, neither of them things they would have done in a free market.

And second, the other factor helping banks that I did not expect in February was the continuation of very low interest rates and the ongoing federal "stimulus." The U.S. Federal Reserve has purchased $2 trillion of U.S. Treasuries, mortgage bonds and agency bonds.

The Obama administration has continued its initiatives, too, such as the $8,000 tax subsidy to first-time homebuyers. This has helped bad banks more than good banks, because the housing-loan and mortgage-bond "books" of the bad banks were in far worse shape.

However, it has enabled all banks to make money simply by borrowing short-term money at a cost close to zero and lending it out to consumers and business at rates often in double digits.

The biggest beneficiary has been Goldman Sachs Group Inc. (NYSE: GS), which has enjoyed a trading bonanza, and which is now intending to pay out record bonuses on the basis of profits made using cheap, taxpayer-provided capital.

No Room for a New Year Encore?

Going forward into 2010, these factors stop being so positive.

First, it's most unlikely that the Fed will keep interest rates at such low levels in 2010. Commodity and oil prices have soared during 2009 because of the low interest rates, and at some point these escalating prices will translate into real inflationary pressures – even down to the consumer level.

When this happens, interest rates will have to go up. That will have three effects on bank profits – all of them bad.

• First it will reduce the huge trading profits that the likes of Goldman Sachs, Citigroup and Bank of America (which owns Merrill Lynch) have been making.
• Second, it will reduce the profitability of borrowing short-term and lending longer-term – indeed the banks that have invested in bonds with the interest rates un-hedged will even incur capital losses.
• Third, and last, the higher interest rates will tend to reduce the prices of assets such as houses and commercial real estate, thus causing larger bad debts.

The government's stress test earlier this year was based on a "worst case" U.S. economic scenario of 10.5% unemployment in 2010 and a 29% decline in U.S. house prices from the beginning of 2009.

Housing prices are now showing signs of having bottomed out only about 8%-10% below their December 2008 level. That's good.

However, the U.S. unemployment rate in October rose by 0.4% to reach 10.2%, and there must be a substantial chance in the new year that the U.S. jobless rate will blow through both the stress test's hypothetical level of 10.5% and the November 1982 postwar record of 10.8%. Combine that with a possible further decline in home prices if interest rates rise, and investors could be looking at some real trouble for the balance sheets of consumer-oriented banking institutions.

Since unemployment has never risen above 10.8% in the postwar period (and its duration above 10% was only 10 months in the rough 1982-83 downturn) the U.S. consumer-credit system is not "stress-tested" for such high unemployment rates.

Losses could be huge.

Of course, the government will very likely bail out the banks again if they get in more trouble. However, shareholders would probably be pretty badly penalized in that event, since politicians would likely conclude that investors should bear more of the cost for zapping taxpayers twice in two years.

That brings me to the other possibility, of punitive legislation against the banks – or some kind of "insurance premium" on those deemed "too big to fail." I'm talking about premiums in addition to those that banks already pay to the Federal Deposit Insurance Corp. (FDIC).

There is considerable political momentum behind this: The news of the record Goldman Sachs bonuses and soaring bank remuneration – coming at a time when the Fed is running policies specially designed for U.S. financial institutions to repair their capital and resume ordinary lending – is pretty compelling. It's not as if the banks were increasing their lending with the money they are being given; bank loans are currently running $600 billion below year-ago levels even as banks have nearly $2 trillion in excess reserves with the Fed.

Personally I would favor a "Tobin tax," a small tax on each transaction in bond, stock commodity and foreign-exchange markets. This would need to be imposed by global agreement, but could be levied on a country-by-country basis (you don't want to give global institutions a separate source of revenue, heaven forbid!).

Tobin taxes would fall most heavily on the very big conventional banks, as well as on the trading-oriented investment banks. They would hit especially hard the "fast-trading" business initiatives, in which investment banks profit from their inside knowledge of money flows.

That's all to the good; the "fast trading" business – and much of trading in general – appears to me to be pure rent extraction in which traders make money without providing anything of value to others. As a veteran banker myself, I can say with certainty that this is not true of most traditional banking and investment banking business, however.

Whatever tax the politicians decide to go with would strike both directly and deeply at bank profitability. If designed badly, this tax could also hurt the relatively innocent regional banks. There is also new talk of breaking up the biggest banks to stop them being "too big to fail" – again probably bad news for shareholders in the short-term.

With markets, loan losses and the government all likely to hurt banks in 2010 – especially in the year's second half – banks are not a savvy investment play right now.

However, there may come a period – perhaps in late spring – at which the overall stock market sees all the problems and again fails to distinguish properly between the badly run or scamming behemoths, and the valuable and well-run regional franchises.

At that point, selected banks will again be a "Buy."

Perhaps – as we saw last February – it will even once again be possible to double your money.

After all, risk does have its advantages!

[Editor's Note: Money Morning's "Outlook 2010" series has already provided readers with a forecast for the U.S. economy in the New Year. Watch for future installments addressing the economic outlook for oil prices, the high-tech sector, retailing, housing, foreign investments and other key topics.]

News and Related Story Links:

• Analysis of the U.S. Banking Sector (Part I of II):
  The Top 12 U.S. Banks: From Zombies to Hidden Gems.
• Analysis of the U.S. Banking Sector (Part II of II):
  Fifth Third – A Medium-Sized "Zombie" Bank.
• Money Morning Analysis of the U.S. Banking Sector:
  Money Morning's Bank Stress Test Says These Three Banks Are the Strongest.
• Money Morning News Analysis:
  Bank Stress Tests: The Results Are in; Now What?
• Wikipedia:
  Tobin Tax.
• Money Morning News Analysis:
  BB&T, Capital One, U.S. Bancorp and KeyCorp Planning Stock Sales to Raise Capital, Repay TARP.
• FDIC.gov:
  Official Web Site.
• Money Morning News:
  Obama Administration Wants New "Pay Czar" and Shareholder Vote to Reign in Executive Compensation.
• Wikipedia:
  Too Big to Fail.
• Money Morning Special Report: First Anniversary of the Financial Crisis:
  Wall Street Back to Business as Obama's Regulatory Overhaul Loses Momentum.
• Money Morning Market Commentary:
  High Frequency Trading: Wall Street's New Rent-Seeking Trick.

Gold has surged 60% in the past 12months and it’s not letting up. The “yellow metal” is continuing that scorching surge into the last part of the year, establishing new highs on a near-daily basis. In fact, gold established yet another record price yesterday (Wednesday) when it peaked at $1,153.40 an ounce on the New York Mercantile Exchange (NYMEX).

And the records are going to keep on coming.

With the U.S. dollar in a freefall and global gold demand rising, analysts say the precious metal will likely continue its bullish trend through at least the first half of 2010. It could rise as high as $2,000 an ounce, which would represent a 73% gain from current record levels.

“Everything is pointing to the price of gold going higher,” Mike Sander, an investment adviser at Seattle-based Sander Capital Advisors, wrote in an e-mailed report.

And “a whopping budget deficit continuing to balloon, a Federal Reserve in no place of raising rates, and central banks all over the world diversifying away from the dollar,” will be the main catalysts for gold’s continued rise, he said.

Indeed, the U.S. Federal Reserve’s loose monetary policy has put the dollar under duress. The central bank has pumped more than $2 trillion into the U.S. economy since the financial crisis began more than two years ago. It has lowered its benchmark Federal Funds rate to a record-low range of 0%-0.25% and it has stepped up purchases of U.S. Treasuries and mortgage-backed securities.

More recently, the return of investor risk appetite and the widespread belief that the Fed will have to keep its stimulus measures in place as the U.S. economy struggles out of a long and deep recession have put downward pressure on the greenback.

The dollar tumbled about 20% against the euro in the past year, and the Dollar Index – which measures the greenback against the euro and five other currencies – fell to a 15-month low of 74.679 on Monday and was retesting that low as of Wednesday.

With the dollar in freefall, central banks and hedge funds have sought shelter in hard assets, particularly gold. That’s a big reason why gold has experienced such a remarkable run this year.

“You have to consider the amount of money sloshing around the world right now – China’s $2.2 trillion in reserves, India’s $285 billion in reserves, all of the money in central banks throughout the Middle East,” said Martin Hutchinson, a contributing editor for Money Morning and a veteran banker with more than two decades experience in the international marketplace. “If all of the serious money charges into gold and gold really gets going, you’ll see a tremendous spike in prices.”

Concludes Hutchinson: “I believe the price of gold will hit $2,000 an ounce next year.”

Such steep run-ups have happened before. From 1978 to 1980, for instance, gold soared from $185 an ounce to $850 an ounce, Hutchinson recalls. Interest rates were about 10% at that time. Credit is much easier to get today.

“Right now, the cost of borrowing money and investing in gold is virtually zero,” Hutchinson said.

How Global Demand Will Drive Gold to $2,000

Indeed, the bull-run in gold is already well underway, and it’s picking up steam.

Prices actually began their most recent rally when the International Monetary Fund (IMF) earlier this month revealed that it sold 200 metric tons of gold to the Reserve Bank of India (RBI) from Oct. 19 to Oct. 30.

The RBI paid $6.7 billion for the 200 metric tons of the yellow metal – the equivalent of about 8% of the world’s annual mine production.

The move surprised many analysts, as India for the past 15 years had largely neglected its gold reserves.

India’s gold holdings peaked at 20% of its foreign exchange reserves – all the way back in 1994. Since that time, India’s gold holdings had fallen:
Indeed, prior to the central bank purchase, India’s gold holdings had dropped to just 3.6% of the nation’s estimated $285.5 billion in foreign reserves.

Little wonder that last month’s gold purchase nearly doubled India’s holdings, which now stand at 558 metric tons, or 6.2% of the nation’s forex reserves.

India’s gold holdings as a percentage of foreign reserves are now higher than even China’s. The People’s Bank of China (BOC) holds about 1,054 metric tons of gold, equal to roughly 2% of its $2.3 trillion in foreign currency reserves.

Asia’s third-largest economy now has the world’s 10th-largest gold reserve, behind Russia, which has about 568 metric tons.

“Our Reserve Bank decided to buy some gold. I think about 400 tonnes. That’s normally something we do from time to time. The IMF wanted to sell gold and we wanted to buy gold,” Pranab Mukherjee, India’s finance minister, said in an interview with the Financial Times.

However, analysts have been far less flippant about the purchase.

Timothy Green, the author of “The Ages of Gold,” described India’s purchase to Bloomberg News as “the biggest single central-bank purchase that we know about for at least 30 years in such a short period.”

“The only comparable event was the U.S.’s steady purchases in the 1930s and 1940s,” he said.

Analysts believe India’s highly publicized purchase – which was made when prices were near record highs – will spawn a chain reaction in which other countries and investors ramp up their gold purchases.

“This is a landmark trade,” Jonathan Spall, a director at Barclays Capital (NYSE ADR: BCS) and a gold specialist, told the FT. “Central banks are conservative institutions and India’s move is a sign for other central banks and sovereign wealth funds that were contemplating buying gold.”

The IMF said in September that it would sell 403.3 metric tons of the metal to shore up its finances and increase its ability to lend at reduced rates to low-income countries.

And with 203.3 metric tons still on sale at the IMF, don’t be surprised if China decides to bulk up on gold, too. China, the world’s sixth-largest holder of gold, has increased its yellow-metal reserves by 76% since 2003. But the 1,054 metric tons it now holds is equal in value to just 2% of its world-record $2.3 trillion in total reserves.

“It is but a matter of time until China and the IMF announce much of the same,” Dennis Gartman, an economist and the editor of The Gartman Letter, told Bloomberg.

Worldwide demand for gold is clearly on the upswing. However, just as that’s happening, supply and production of the precious metal are falling.

Annual worldwide mine production of gold has decreased by nearly 8% since 2001, even as the price of gold has tripled.

Meanwhile, investment demand for gold remained very strong – surging 46% in the second quarter of 2009 from a year ago, according to the World Gold Council.

“Everyone who says that gold will hit $2,000 in five years is wrong,” said Money Morning’s Hutchinson. “It will be back down in 5 years. If it’s going to $2,000 it will get there next year.”

“It will turn around when [central banks] start taking monetary policy seriously, and they won’t do that in a hurry,” he added. “Gold’s bull run is a bubble, just like all the other bubbles.  Except this is more of a bang than a bubble, because it’s taking place so quickly.”

Four Ways to Play Gold

1. Market Vectors Gold Miners ETF (NYSE: GDX): Gold miners benefit disproportionately from a rise in the price of gold, because their production costs are fixed. This means that miners are a more-leveraged way to play gold than the metal itself, particularly since surging speculative demand can increase mining companies’ Price/Earnings (P/E) ratios.
2. SPDR Gold Shares ETF (NYSE: GLD): GLD holds more than 1,000 ounces of gold, and has a market capitalization of $39 billion. As an investment, GLD is more convenient than buying gold bars directly. The fund’s share price fluctuates in concert with the price of gold.
3. Barrick Gold Corp. (NYSE: ABX): Barrick is the largest and financially strongest gold producer, with a market capitalization of $43 billion, reserves of 124.6 million ounces of gold (plus copper and silver), and operations in North America, South America, Australasia and Africa.
4. Yamana Gold Inc. (NYSE: AUY): A growing gold producer with a $6.8 billion market capitalization that made an unexpectedly good profit in the fourth quarter of 2008, Yamana is expanding both production and reserves (currently 19.4 million ounces) with operations in Canada and Latin America. Its expansion magnifies the likely potential benefit from an increase in gold prices.

[Editor’s Note: Money Morning’s “Outlook 2010” series has already provided readers with a forecast for the U.S. economy in the New Year. Coming up next week will be a report on the outlook for the banking sector. Watch for future installments addressing the economic outlook for oil prices, the high-tech sector, retailing, foreign investments and other key topics.]

News and Related Story Links:

• Money Morning “Outlook 2010” Economic Forecasting Series (U.S. Economy Part I):
  U.S. Economy Will Dodge a Double-Dip Downturn, But Won’t Escape Unemployment Woes During 2010 Jobless Recovery.
• Money Morning “Outlook 2010” Economic Forecasting Series (U.S. Economy Part II):
  When Stimulus Spending Winds Down, Will U.S. Businesses Step in For Tapped-Out Consumers?
• Money Morning: News Analysis:
  Gold to Continue its Record Run as Central Banks Stock Up.
• Money Morning Special Investment Report:
  Five Ways to Ride the Commodities Bull.
• Money Morning News Analysis:
  Who’s Benefiting from the Dollar’s Demise?
• Money Morning News:
  Gold Prices Soar to 18-Month High on Dollar Weakness, Inflation Fears.
• Money Morning:
  The “Golden Staircase” Points to Record Prices for Gold.
• Bloomberg News:
  Gold Rises to Record on Dollar, Central-Bank Buying Speculation.
• Financial Times:
  India flexes its foreign reserve muscles.
• MarketSkeptics.com:
  Foreign Exchange Reserves Explained.
• Wikipedia:
  Pranab Mukherjee.
• Financial Times:
  Gold extends record high on India purchase.
• Bloomberg News:
  Gold Climbs to Record as India’s Central Bank Buys IMF Bullion.
• Money Morning:
  The Three Triggers of the Global Gold Bubble.
• Money Morning Research Report:
  As Junior Miners Cash in on Soaring Inflation and Growing Global Demand, So Can You.
• International Monetary Fund:
  Official Web Site.
• Money Morning News Analysis:
  Gold to Continue its Record Run as Central Banks Stock Up.
• Wikipedia:
  Mortgage-Backed Security.
• Money Morning Outlook 2008 Economic Forecasting Series:
  Outlook 2008: Three Ways to Profit From Sovereign Wealth Funds – the “Next Wall Street”.
• World Gold Council:
  Official Web Site.
• Investopedia:
  Price/Earnings Ratios.
• The New York Times:
  Fed to Begin Buying Mortgage-Backed Securities.

It's no secret that government spending has been fueling much of the growth in the $14.2 trillion U.S. economy. And if consumers aren't ready for the handoff when that stimulus spending winds down – and they certainly don't appear to be – it will be up to the U.S. business sector to carry the ball.

And it's not at all clear that Corporate America is ready, willing or able to fulfill that role.

For one thing, companies just aren't hiring en masse. That means the current economic rebound is actually a "jobless recovery," and could be vulnerable to unforeseen shocks, San Francisco Fed President Janet Yellen told an audience during a speech in Phoenix, Ariz, earlier this month.

"Unemployment could stay high for several years to come," Yellen said during the speech that was given less than a week after the U.S. Federal Reserve left interest rates unchanged at near zero. "High unemployment, weak job growth and paltry wage increases are a recipe for sluggish consumer spending growth and a tepid recovery."

U.S. Businesses Throttle Back on Spending Plans

Even though a recently released government report showed that the U.S. economy grew at a 3.5% annual rate in the third quarter, 75% of economists polled in a separate survey concluded that the gross domestic product (GDP) number will be revised downward in the future. The key reason for that belief: The U.S. unemployment rate is expected to keep rising in the new year, heightening the prospects of a jobless recovery.

Small businesses, which employ more than half of all private-sector workers – and which have generated 64% of all new jobs over the past 15 years – are not even close to picking up the slack.

In fact, 16% of small-business owners surveyed by the National Federation of Independent Business said they are planning to cut jobs in the next three months – nearly double the number of those planning to add jobs.

"The 'job generating machine' is still in reverse," the federation said.

A survey of 1,537 chief financial officers in the latest Duke University/CFO Magazine Global Business Outlook Survey showed that most large U.S. companies do not plan to increase capital spending in the near future.

Furthermore, 56% of U.S. companies say they are still being adversely affected by credit-market conditions. Among those negatively affected, two-thirds say the cost of credit is their biggest problem, and half say credit is simply less available. That can't help but stifle GDP growth.

"For full economic recovery we need to see capital spending increase by double digits, rather than simply treading water as we're seeing now," said John Graham, a finance professor at The Fuqua School of Business who is also the director of the CFO Magazine survey.

Most firms will take several years to return to pre-recession employment levels and some expect to operate with permanently reduced workforces. Unemployment could reach 10.5% before leveling off in the third quarter of 2010, further crimping consumer spending.

"We'll see a steeper decline in investment and business structures and a little less growth in residential investment," said Randell Moore, editor of the Blue Chip Economic Indicatorsnewsletter.

Money Morning's Outlook: U.S. businesses – big and small – have embraced a leaner, lower-cost mindset that leaves firms reluctant to hire and reticent about making capital investments other than those that can't be avoided. That will prolong the jobless recovery, and result in lower contributions to U.S. GDP growth by both consumers and businesses. But there is a benefit. With this newfound frugality, companies should be able to maintain – or even boost – profitability, even during a sluggish revenue environment. That, in turn, could be good for U.S. stock prices, and for the ongoing stock-market rebound.

Unemployment Handcuffs the Fed

In an effort to get the economy on its feet, the government so far has put up at least $3.27 trillion in stimulus programs, including the American Recovery and Reinvestment Act and the Troubled Asset Relief Program (TARP).

According to Standard & Poor's Inc. (NYSE: MHP), only about a third of the $787 billion stimulus package has hit the U.S. economy. Most of the infrastructure spending is just getting started now after being delayed by both the political and bidding processes.

Additionally, the Federal Reserve since last March has kept the benchmark Federal Funds rate for overnight lending to banks at between zero and 0.25%. More recently, the Fed has promised to keep rates "exceptionally low" for "an extended period."

The unemployment rate has never peaked inside a recession and the Fed has never raised interest rates while unemployment was still rising. That means that all signs point to the central bank continuing its current lending programs until unemployment starts to subside.

Despite the U.S. dollar's decline and the recent surge in the price of oil, gold and other commodities, the fear of inflation is probably unwarranted, U.S. Federal Reserve Chairman Ben Bernanke and other policymakers contend.

Economists who subscribe to this viewpoint say that inflation is currently at acceptable levels and overcapacity will continue to cast a long shadow over the housing and labor markets. Some believe we might even see deflation within the next 18 months.

Just yesterday (Tuesday), in fact, the Labor Department reported that "core" producer prices – which exclude such volatile items as food and energy – posted an unexpected moderate decline for October. The 0.6% decrease for October followed a 0.1% decrease in September. That surprised economists, who had been expecting core prices to increase 0.1%.

However, overall producer prices increased 0.3% in October after an unrevised 0.6% drop in September. Big jumps in food and energy prices powered the increase. Energy prices soared 1.6% in October after falling 2.4% in September, while food prices also rose 1.6%, after a 0.1% decline the month before.

"Core producer price inflation accelerated above 4.5% during the boom in the latter part of the previous cycle, but plunged during the recession," FTN Financial Group Chief Economist Chris Low said in an interview with RTTNews. "Core producer prices tend to bottom a year or two after recessions, so there is still disinflation to come at the wholesale level."

But there's another school of thought – one that says that the policies now being followed will fan the flames of inflation and cause an inflationary conflagration the likes of which the country hasn't seen since the 1970s and early 1980s. If that inflationary escalation comes while unemployment remains high it could turn into "stagflation," a culprit that's hard to vanquish once it's gone to ground.

A report on consumer prices will be released today (Wednesday). Economists expect overall consumer prices to increase 0.2%, with "core" consumer prices rising 0.1%.

Regardless of what school of thought you subscribe to, look for the government to keep the pedal to the metal. The Fed won't hike rates before late 2010, most likely after the mid-term elections. And while talk of a "second stimulus" is surfacing once again, it's also possible that any additional spending programs will be put on the back burner by the burgeoning $2 trillion deficit, which is approaching 10% of GDP.

Money Morning's Outlook: Fed policymakers are in a tough spot: Raise rates too soon and they choke off the recovery; wait too long to boost borrowing costs and they've spawned potentially ruinous inflation – and possibly even stagflation. Investors will need to spend some serious time watching the Fed in the New Year, while closely tracking such statistics as unemployment and commodity prices.

[Editor's Note: Part I of Money Morning's U.S. economic analysis of what's to come in 2010 appeared yesterday (Tuesday). To read that story, please click here. Part I focused on the overall outlook for growth in the New Year and examined how the "jobless recovery" would impact consumer spending.]

News & Related Story Links:

• Money Morning:
  Jobless Recovery Category
• Reuters:
  Stronger U.S. GDP Seen in 2010: Survey.
• Los Angeles Times:
  Obama to hold job forum in December
• Money Morning:
  Unemployment Rate Cracks Double-Digit Barrier at 10.2%, Boosting the Odds of a "Jobless Recovery"
  
• MarketWatch:
  Small-business owners skeptical of recovery
  
• CFO Survey:
  CFO optimism improves, but employment outlook is bleak
  
• MSN.COM:
  What comes after 10% unemployment?
  
• Reuters:
  U.S. jobless rate to peak at 10.5 pct, Fed on hold – poll
  
• MarketWatch:
  Fed's Yellen see signs of jobless recovery
  
• Standard & Poors:
  U.S. Economic Forecast: Panic Is Being Replaced By Fear.
• Knowledge@W.P. Carey:
  2010 Economic Forecast: Don't Hold Your Breath
  
• Naroff Economic Advisors:
  Monthly Economic Review.
• 401K.fidelity.com:
  The Road Map to Recovery: Leading Economic Indicators.
• Duke University Fuqua School of Business:
  Official Web Site.
• Money Morning Week Ahead Column:
  Is a Second U.S. Stimulus Package Headed Our Way?
  
• Wikipedia:
  Federal Funds Rate.
• RTT News:
  Core Producer Prices Show Unexpected Decrease In October.

Historically, the U.S. stock market has been one of the key leading indicators of a U.S. economic rebound.

With the Standard & Poor's 500 Index up more than 60% from its March lows – and the Dow Jones Industrial Average up nearly 40% – prognosticators are finally confident that the U.S. economy will dodge the "double-dip" recession that has been the focus of much fear since the Bush and Obama administrations launched their financial counterattacks on the worst financial crisis since the Great Depression.

But those same forecasters are reluctant to forecast a sharp economic rebound for 2010. In fact, as opposed to a classic "V-shaped" economic recovery that would accelerate as the year goes on, many economists are predicting that the rate of growth will slow as the New Year unfolds.

Forecasts from Standard & Poor's Inc. (NYSE: MHP) and Goldman Sachs Group Inc. (NYSE: GS) illustrate this outlook. S&P recently projected average GDP growth of 1.6% for all of 2010, while top Goldman Sachs economists expect to see the U.S. growth rate decline from 3% early in the year to 1.75% by the fourth quarter.

"We don't expect a V-shaped recovery; in fact we think that 2010 is going to be a bit slower in terms of annualized GDP growth than the second half of 2009," Goldman Sachs Chief U.S. Economist Jan Hatzius said during a recent speech in New York City.

For analysts and economists who play the forecasting game, 2010 promises to be one of the toughest challenges in decades.

Unemployment has pierced the psychologically daunting 10% level, placing U.S. joblessness at its highest level in a quarter century. Serious questions remain about the strength of the country's banking and financial systems. The U.S. dollar is under siege and inflationary concerns are at their highest levels in years. There's massive uncertainty about the nation's residential and commercial real estate markets. And even the stock-market rebound – one of the strongest in history – is considered suspect by some analysts: They worry that federal stimulus money and the U.S. Federal Reserve's "zero-interest-rate policy" has forced bearish investors to become reluctant bulls.

Among the difficulties would-be forecasters currently face economists face is the fact that 4% of the economic growth in recent months is attributable to temporary factors, most notably the replenishing of inventories and government fiscal stimulus, Goldman's Hatzius said. Those factors are likely to diminish by the second half of 2010, due to high unemployment, budget-conscious consumers, and overcapacity in the manufacturing sector and housing markets.
Despite these obvious difficulties, the outlook for 2010 is far from dismal. Among the bright spots:

• The stimulus seems to be having its intended effect – one reason the odds of a double-dip recession remain remote.
• The U.S. housing market – a crucial element of the consumer sector – is showing signs of bottoming out.
• The weak U.S. dollar is making U.S. exports highly competitive, giving a much-needed boost to American manufacturers.
• With their reluctance to hire, businesses are clearly operating in a highly cost-conscious zone – a reality that could bode well for corporate profits, and for stock prices.
• And the overall outlook for the U.S. economy is much better than it was a year or 18 months ago, and actually continues to improve – albeit slowly – a reality that can feed on itself to further bolster growth.

In this leadoff story in Money Morning's Third Annual "Outlook" forecasting series, we'll take a look at overall expectations for the U.S. economy for the New Year, will consider four key challenges, and will give you our take on each one. The areas that we'll explore will include:

• Economic expectations and the odds of a double-dip downturn.
• The odds for maintaining growth with a "jobless recovery."
• The outlook for business investment and spending.
• And the risks and rewards of current central bank policies.

Let's take a look …

Handicapping U.S. Growth in 2010

A new survey concluded that top economic forecasters have grown in confidence that the U.S. recovery is sustainable. But those analysts also expect that growth will fall short of the typical post-recession rebound, the Blue Chip Economic Indicators newsletter reported in its November issue.

The U.S. economy should expand 2.7% next year, the consensus estimate of 52 economists polled by the newsletter. That's an upward revision from the consensus prediction of 2.5% made just one month before.

"The major uncertainty surrounding the outlook for growth next year involves the degree to which private demand accelerates as the positive contributions to GDP from reduced business inventory liquidation and fiscal stimulus play out," the newsletter said.

Those factors alone pose some significant challenges to a robust rebound. Add in the near-certainty that this recovery will be a jobless one – as well as the fact that most economists believe that U.S. growth will slow, and not accelerate – as 2010 progresses, and it might be overly optimistic to expect a growth rate of 2.7%, which is how well the economic often performs even during healthy periods.

Money Morning Chief Investment Strategist Keith Fitz-Gerald is forecasting growth of, at best, 2.0% in 2010, a key reason he continues to tell investors to look abroad for some of the most-profitable investment plays.

The U.S. economy "will be lucky to do 2.0% " next year, Fitz-Gerald said. "The economy faces some very difficult challenges. There's a slight chance – depending on what happens with some outside factors – that the U.S. could do 2.5%, but I really doubt it. China could actually pull us along [to higher-than-expected growth], but those are some long odds."

That's not to say that 2.0% growth is bad news. That's more than enough to negate the odds of a double-dip recession. Indeed, after reviewing U.S. economic history all the way back to the 1850s, Deutsche Bank AG (NYSE: DB) economists recently found that double-dip recessions are exceedingly rare.

And Money Morning Contributing Writer Jon Markman notes that when these double-dip downturns do occur, they happen under circumstances quite different from the ones that we face today. Reprised recessions usually occur in concert with a fight against inflation.

"A repeat of the 1980s just isn't in the cards," Markman said.

Money Morning's Outlook: Overall, the likelihood is that the U.S. economy will experience slow GDP growth. In terms of the average growth rate for the year, investors are most likely looking at a range of 1.0% to 2.0% for all of 2010, as a protracted jobless recovery extends the housing and banking crisis, puts a damper on wages, reduces consumption. And that growth rate will decelerate as the year progresses, meaning that it's measure investors should watch closely.

U.S. Joblessness Will Stifle Consumer Spending

As we've all learned as far back as Econ 101, the U.S. marketplace is chiefly consumer driven. Historically, consumer spending spurred 60% of U.S. growth. In recent years, that number has surged as high as 70%. Given the U.S. economy's avowed consumer focus – coupled with the near-certainty that we're facing a jobless recovery – investors who are hoping for stronger-than-expected growth would best keep the champagne on ice, according to economist Joel Naroff.

"We need households to become a little more confident and businesses to start thinking about tomorrow so we can transition out of the government- and Fed-supported economy into a private-sector recovery," Naroff, president of the Holland, PA-based Naroff Economic Advisors, said in a note to investors.

To that end, Naroff is concerned about the effect a jobless recovery could have on consumer spending.

"Can consumers save the day? Only if incomes grow solidly and that is not going to happen … businesses have some room to expand without hiring lots of new employees," Naroff noted. "It could take four to five years for the unemployment rate to get back to full employment. There is little reason to expect that happy times are here again."
The U.S. unemployment rate in October pierced the psychologically important 10% barrier for the first time since 1983, as employers made deeper-than-predicted payroll cuts.

It's no surprise, then, that U.S. consumers in September cut their spending for the first time in five months, reducing their outlays for products and services by a hefty 0.5%.

Only one other time since World War II has the unemployment rate topped 10% – between September 1982 and June 1983. It hit 10.1% in September 1982, moving up from 9.8% the month before.

The economy, as measured by gross domestic product (GDP), was basically flat in summer 1982. But the economy at that time was actually getting ready to recover.

Then the economy began to surge in early 1983, fueled by tax cuts and, more importantly, substantial interest-rate cuts by the Federal Reserve. By the end of 1983, the unemployment rate was down to 8.3% and dropped to 7.3% in 1984 and 7.0% in 1985.

But that was then and this is now.

Although the official unemployment rate hit 10.2% last month, the employment outlook is actually much worse: If you factor in part-time workers who'd prefer a full-time position, and people who want work but have given up looking, the "real" unemployment rate is actually a record-high 17.5%.

That means that more than 16 million people are now out of work, compared to 6 million in 1982. In July – the last month the government released statistics – there were more than six officially unemployed persons for every job opening. Historically, the ratio is closer to 2-to-1.

What's worse is that productivity is increasing as employers are successfully getting their existing staff to produce more in fewer hours – making it less likely they will start hiring.

Any improvements will come slowly. In the Blue Chip Economic IndicatorsNovember issue, 52% of the economists surveyed said the unemployment rate won't fall back below the 7.0% level on a sustained basis until the second half of 2013 – and it may take longer than that.

Money Morning's Outlook: The recession may technically have ended, but for the millions of unemployed workers the hard times are far from over. Given that almost one-fifth of the U.S. work force is unemployed or underemployed, don't expect consumers to step up and step in if stimulus spending falls short, or ends. The upshot is that, from this vantage point, GDP growth for the New Year is likely to be severely constrained.

[Editor's Note: Part II of Money Morning's U.S. economic outlook story will appear tomorrow (Wednesday). Part II will focus on business spending and the U.S. Federal Reserve.]

News & Related Story Links:

• Money Morning:
  Jobless Recovery Category
• Reuters:
  Stronger U.S. GDP Seen in 2010: Survey.
• Los Angeles Times:
  Obama to hold job forum in December
• Money Morning:
  Unemployment Rate Cracks Double-Digit Barrier at 10.2%, Boosting the Odds of a "Jobless Recovery"
• MarketWatch:
  Small-business owners skeptical of recovery
• CFO Survey:
  CFO optimism improves, but employment outlook is bleak
• MSN.COM:
  What comes after 10% unemployment?
• Reuters:
  U.S. jobless rate to peak at 10.5 pct, Fed on hold – poll
• MarketWatch:
  Fed's Yellen see signs of jobless recovery
• Standard & Poor's:
  U.S. Economic Forecast: Panic Is Being Replaced By Fear.
• Knowledge@W.P. Carey:
  2010 Economic Forecast: Don't Hold Your Breath
• Naroff Economic Advisors:
  Monthly Economic Review.
• 401K.fidelity.com:
  The Road Map to Recovery: Leading Economic Indicators.
• Duke University Fuqua School of Business:
  Official Web Site.
• Money Morning Week Ahead Column:
  Is a Second U.S. Stimulus Package Headed Our Way?